The new political economy of central banking

Paper to be presented at the conference "Monetary Theory as a Basis for Monetary Policy" Many observers believe that countries with an independent central bank have lower levels of inflation than do countries with a central bank that comes under direct control of the government. Why would central bank independence, ceteris paribus, yield lower rates of inflation? The literature (for a survey, see also Eijffinger and De Haan, 1996) provides three answers to this question: public choice arguments, the analysis of Sargent and Wallace (1981) and arguments that are based on the time inconsistency problem of monetary policy. According to thèolder' public choice view, monetary authorities are exposed to strong political pressures to behave in accordance with the government's preferences. 1 Monetary tightening aggravates the budgetary position of government: the reduction in tax income brought about by a temporary slowdown of economic activity, possibly lower receipts from`seigniorage', and the short-run increase in the interest burden on public debt all worsen the deficit. Thus, the government may preferèasy money.' Indeed, some evidence exists that even the relatively independent Federal Reserve caters to the desires of the President and/or the Congress. This evidence is either based on close inspection of the contacts between the polity and the central bank (see e.g. Havrilesky, 1993, 2 and Akhtar and Howe, 1991) or builds on tests to determine whether monetary policy turns expansive before elections as predicted by Nordhaus's (1975) political business cycle theory (see e.g. Allen, 1986), or diverges under administrations with different political orientation, as predicted by Hibbs's (1977) partisan theory (see e.g. Alesina, 1988). At this stage, it suffices to conclude 1 As Buchanan and Wagner (1977, pp. 117-18) put it: "A monetary decision maker is in a position only one stage removed from that of the directly elected politician. He will normally have been appointed to office by a politician subject to electoral testing, and he may even serve at the pleasure of the latter. It is scarcely to be expected that persons who are chosen as monetary decision makers will be the sort that are likely to take policy stances sharply contrary to those desired by their political associates, especially since these stances would also run counter to strong public opinion and media pressures ... `Easy money' is alsòeasy' for the monetary manager ..". 2 Havrilesky (1993) even argues that "the contemporary view is that the Administration, while granting significant …